RETAIL investors have taken to mutual funds in a big way. It is, thus, small wonder that we have so many funds to choose from. So, how do we choose between these funds?
Analysts, typically, use a tool called the Sharpe ratio. This is a ratio that compares the mutual fund returns with a benchmark return. This is done to account for the risk assumed by the fund manager to generate returns.
Take an equity fund, say, Fund `A'. Now, suppose Fund `A' generates returns of 17.5 per cent for 2000. You first compare this performance against a benchmark, say, the S&P CNX Nifty index.
You calculate the daily returns for Fund `A' and the Nifty Index. Then, take the difference in daily returns between Fund `A' and Nifty Index. If the difference is positive, it means that Fund `A' has generated returns in excess of the benchmark Nifty Index.
To find out how much risk the fund manager has taken to generate the returns, you take the standard deviation of the difference returns.
The last step is to divide the difference returns by the standard deviation. This gives us the Sharpe ratio for the fund. You simply select the fund that gives a higher Sharpe ratio.
Let us suppose Fund `A' generates 17.5 per cent with a standard deviation in difference returns of 15 per cent; Fund `B' generates 20 per cent with a standard deviation in difference returns of 35 per cent. Further, suppose that the benchmark Nifty index returns is 10 per cent.
The Sharpe ratio for `A' is 0.5 ([17.5-10]/15) whereas it is just 0.29 for `B' ([20-10]/35). You, therefore, choose Fund `A' for investment.
In the normal scheme of things, you would have chosen `B' as it provides a higher return. The Sharpe ratio, however, shows that `B' assumed a far higher risk to generate a return of 2.5 per cent more than `A'. In other words, `A' performed well on a risk-adjusted basis.
So, it helps to arm yourselves with the Sharpe ratio the next time you face the ordeal of choosing one fund over the other.
Source : Using Sharpe ratio for MF investing